Rising Yuan in China

The biggest event in global financial markets this past week was China finally agreeing to de-peg the yuan from the U.S. dollar. The announcement caused Chinese stocks to rally, even as U.S. stocks sold off, and it was especially excellent news for Chinese companies that are largely focused on the rise in China’s domestic consumption — the biggest beneficiaries of a yuan appreciation.

Companies that focus on Chinese domestic consumption and infrastructure investment are the biggest winners from yuan appreciation because:

They get paid in yuan, which becomes more valuable,

Chinese consumers have more money to buy goods and services,

Their assets are denominated in yuan, and will appreciate in U.S. dollar terms.

Commodity plays will also benefit from this appreciation, and I expect to add more commodity plays in China Strategy in the second half of the year — but for now, we’ll focus mostly on consumer and infrastructure plays as they are the most direct winners.

In fact, for several months now I’ve predicted that China would allow its currency to appreciate beginning in the second-half of 2010 — pretty good timing on my part, considering that the second half of the year is just a week away and I’ve already focused my China Strategy portfolio to take advantage of this expectation.

Back on May 20th, after a climactic sell-off in Chinese stocks, I predicted that the next 5% move in my stocks will be up rather than down. The boom I saw in China further reinforced my belief that the Chinese economy is incredibly strong.

Even after the sell-off this week, those stocks are up more than 5% on average since then. That is why investors need a China expert who understands financial markets in today’s difficult market conditions. This move off the bottom is just the beginning. I expect to see a rally between 40% to 60% from the May 20th levels before year-end. There is more to come.

But though the Chinese government has agreed to let the yuan appreciate, it plans to do so both gradually and when it feels the time is right. I expect that movements in the yuan will tend to be slow, with few jumps. China’s government doesn’t want to encourage speculators or huge currency inflows.

Overall, I think that the yuan will appreciate by around 3% for the rest of the year. This 3% projection is based on my source who works at a major state owned bank in Beijing. This number is the consensus right now on Beijing’s Financial Street. Looking forward, during the next three years I expect that the yuan will likely move up by more than 12% against the dollar.

Now, one reason for China’s timing was because the nation had been under pressure from the rest of the world, especially the U.S. and the Group of 20 nations to let its currency appreciate, as we have discussed in previous issues of China Strategy. So, I expect that the move will also likely lead to a certain degree of political goodwill for China. The move showed the world that China is flexible and willing to cooperate when necessary. Given the problems in developed economies, cooperation with China is more important than ever.

So, why is a stronger yuan good for China and the China Strategy portfolio? Well, as we have discussed, a stronger yuan increases Chinese domestic purchasing power — the primary factor driving both earnings and the share price performance of our Chinese companies.

So, as a result of this jump in domestic purchasing power, China will spend more on assets abroad, especially natural resources, Chinese domestic consumption will sharply increase, and stocks and real estate denominated in the Chinese yuan will become more valuable.

The bottom line is that in light of China’s currency move, I think we will continue to see the relative outperformance of Chinese stocks when compared to U.S. stocks. Already, China stocks have on average moved up much more than the S&P 500, and after the rallies in the past four weeks, Chinese stocks are now generally trending up.